When I was a kid I was a pretty frequent flyer, mostly New York – Los Angeles (and I became a frequent People Express customer out of Newark). I used to get to the airport super early hoping to get a bulkhead seat. This was before elite seating, the best way to get the seats was to be first.
See, there’s a limited number of exit rows and bulkheads on any given seat. One way to ration them is first come first served, or a modified version of who shows up at the airport first. Then they go to whomever has the lowest value of time.
Another way to ration them is to charge for them, whomever values them the most will pay. And that’s what the airlines are doing now (though in many cases elites don’t get charged, though Delta now offers a fare class that doesn’t even allow their Diamond medallion members to pre-assign any seats, let alone have the best seats free).
And when there’s a limited supply of something that customers want, it makes sense to charge for it, lots of things are getting unbundled from ticket price.
But then there are things where one customer’s taking advantage of a service doesn’t detract from another’s ability to take advantage of it. And where one more customer taking advantage of the service doesn’t really add any costs to the airline once the infrastructure is in place.
In those cases, it doesn’t make sense to charge, in fact the airlines will make more money by bundling those services into price — except for two current distortions, technology and tax policy, which I anticipate will be short-lived.
Which is why I expect the future to include more unbundling, more ancillary fees than we have today, but for completely different items than we now see them. Ten years from now I do not believe airlines will charge extra for a first checked bag.
Oh, there will still be limitations on checked baggage. There’s limitations on how much a given plane can carry, or a margin at which checked bags trade off with cargo. An airline ticket will not become a free pass to airlift supplies.
But once an airline builds an infrastructure, and airports build infrastructure and build those costs into the fees for landings and gates, and once airlines buy the trucks and other equipment to move baggage and hire baggage handlers, there’s little extra cost for one more bag.
And, for that matter, once an aircraft is equipped with internet and once the ground-based or satellite-based services are in place, an incremental user of onboard internet is cheap (though there are bandwidth limitations, so it may not be free or at least for doing much beyond basic email there could well be a charge for awhile until bandwidth limitations are overcome).
Here’s why baggage charges exist today. It isn’t the traditional story that airlines saw high fuel prices and had to figure out a decent way to eek out more revenue in order to be profitable. Because it either makes sense to separately charge for baggage or it doesn’t, fuel costs don’t really change that calculation.
Fuel costs probably did force airlines out of their complacency. They used to give away things that they really could charge extra for, not every seat is equal but years ago every seat had the same price, or at least once you bought your ticket you could buy any seat 9and then there were some seats that began to get charged for and that’s been expanding over the past decade).
The reason baggage fees exist, and to some extent many other fees as well, is two-fold:
- Technology.People buy airfare on price, the major sales venues show you a ticket price but not a total trip priced customized to how an individual will travel. And flights are displayed on the basis of price usually, lowest price first, so stripping things out of base price makes sense in order to generate more bookings from consumers for whom assembling total trip cost is pricey information search. Greater disclosure here isn’t the answer, there’s plenty of disclosure already, it’s search cost and most consumers don’t invest. Eventually technology will shift, sales outlets are looking for a competitive edge (booking engines are to a large extent a commodity product), and that investment will lead to greater transparency. No more fooled consumers.
- Taxes. Ancillary fees are generally exempt from the 7.5% excise tax on domestic airfare. So moving $20 away from a ticket and into a bucket of fees means that the government takes $1.50 less. Multiply that out by billions of dollars and it’s real revenue gained through tax arbitrage. My bet is that it’ll take awhile, airlines will give plenty of money to politicians hoping to stave off the excise tax being applied to these fees, but ultimately it’s too big a pot of money for the government to ignore and the tax arbitrage opportunity will go away.
With improvements in technology and closing of tax opportunities, two of the biggest drivers of market distortion that lead to airline ancillary fees will be eliminated.
But that won’t lead to the end of fees.
Bundling makes sense as a revenue-maximizing strategy for airlines and as a consumer welfare strategy for consumers when the services bundled have low marginal cost, like (under certain conditions) baggage fees and onboard internet.
The best analogy here is going to be pay television, cable or satellite. And for this understanding I thank a post at Marginal Revolution. The economics of bundling is often written about in terms of monopolies, though it hardly seems to require such, e.g. even where cable is a monopoly it competes with satellites and satellite services compete and bundle.
Why are consumers forced to buy a bundle? Cable companies claim that choice would require expensive boxes, but few observers believe this claim.
More plausibly, price discrimination is at work. Consider a simple example with two individuals. John values Disney at $100 a year and FoxNews at $10 a year; Sally has the reverse valuations. Without bundling, the cable company will offer each channel for about $99, and sell a channel to each consumer, reaping $198 in revenue (N.B.: I am assuming that the cable company has a good idea of demand in general, although it cannot identify which consumer is willing to pay how much for what.)
In lieu of this set up, sell the bundle for $109 to each consumer, reaping a greater revenue of $218. The company makes greater profit.
More importantly, aggregate welfare is higher. In this case each consumer receives two channels instead of one.
Bundling makes sense where consumers demand various levels of service, will pay different amounts for each service, and the marginal cost to provide services is low. Once the investment is made to be able to to provide the service, the key is to extract as much total revenue from all of your customers as possible.
And this concept of extracting greater revenue from consumers makes sense nowhere more than the airline industry which is capital intensive and where some of the most pioneering work in price discrimination (through revenue management) has been done.
Plenty of people choose not to check bags at $25 apiece, they shove all their stuff into carryons and fill the overhead bins and maybe wind up checking the bag anyway just by getting it through security once the bins fill up. And that stresses departure times as well.
But they might have paid $5 not to have had to deal with the bag post-security, or to bring a bit bigger bag that wouldn’t have fit through the x-ray. And today that $5 is actually left on the table, but the airlines aren’t going to price the bag separately at $5, but eventually ticket prces will be probably $5 higher or a bundle of premium services for $25 might include baggage and seiveral other things that consumers value a little but that in total they value above that $25 price point. The airlines will make more money, and the people who would have checked the bag for $5 will be better off, it’s actually win-win.
In the future it may be that baggage and internet are bundled into ticket price, or just into a premium services package. Today baggage, priority waitlisting and checkin and boarding, amongst other benefits are ‘bundled’ into an elite benefits package that is sold to customers in flying packages (flying a whole lot to earn status) and at some airlines on a day of travel basis.
The future of fees will look very different than it does today, once technology and government distortions change, and as airlines compete over the pot of available ancillary revenue from consumers (the phenomenon is still relatively new). Fees are here to stay, but I’m betting that 10 years from now it will not be $25 a bag.